Monthly Archives: September 2015

In my most recent posts, I discussed the importance of using the proper semantics when discussing monetary policy. Central bankers should have an explicit numerical target for a goal variable. They should then describe how they are going to adjust their instrument to achieve this target, with particular reference to the intermediate variables that will provide guidance at higher frequencies. A related issue is that a central bank is limited in terms of its ultimate target (or targets) by the number of instruments it has at its disposal. This is discussed in an excellent post by Mike Belongia and Peter Ireland:

More than sixty years ago, Jan Tinbergen, a Dutch economist who shared the first Nobel Prize in Economics, derived this result: The number of goals a policymaker can pursue can be no greater than the number of instruments the policymaker can control. Traditionally, the Fed has been seen as a policy institution that has one instrument – the quantity of reserves it supplies to the banking system. More recently, the Fed may have acquired a second instrument when it received, in 2008, legislative authority to pay interest on those reserves.

Tinbergen’s constraint therefore limits the Fed to the pursuit, at most, of two independent objectives. To see the conflict between this constraint and statements made by assorted Fed officials, consider the following alternatives. If the Fed wishes to support U.S. exports by taking actions that reduce the dollar’s value, this implies a monetary easing that will increase output in the short run but lead to more inflation in the long run. Monetary ease might help reverse the stock market’s recent declines – or simply re-inflate bubbles in the eyes of those who see them. Conversely, if the Fed continues to focus on keeping inflation low, this requires a monetary tightening that will be expected, other things the same, to slow output growth, increase unemployment, and raise the dollar’s value with deleterious effects on US exports.

The Tinbergen constraint has led many economists outside the Fed to advocate that the Fed set a path for nominal GDP as its policy objective. Although this is a single variable, the balanced weights it places on output versus prices permit a central bank that targets nominal GDP to achieve modest countercyclical objectives in the short run while ensuring that inflation remains low and stable over longer horizons. But regardless of whether or not they choose this particular alternative, Federal Reserve officials need to face facts: They cannot possibly achieve all of the goals that, in their public statements, they have set for themselves.